What is Put-Call Ratio and why is it important?

The Futures & Options market is a key market where risks are hedged and traders also take leveraged bets on specific stocks and also on indices. A call option is a right to buy an underlying asset (stock or index) at a predetermined price without the liability to buy. A buyer of the call option pays the premium for this right to the seller of the call option. A put option is a right to sell an underlying asset (stock or index) at a predetermined price without the liability to sell. A buyer of the put option also pays the premium for this right to the seller of the put option.

Typically, you buy call options when you are expecting the price of the stock or the index to go up. Therefore, buying a call options is a bullish signal. Similarly, you buy put options when you are expecting the price of the stock or the index to go down. Therefore, it is a bearish signal. When we combine the puts and calls together we can glean a variety of signals for the market as a whole.

Put call ratio (PCR) can be looked at in two ways. We can calculate the PCR of volumes which is the ratio of the volumes on the puts of a particular contract to the calls of that contract. PCR can also be looked in terms of PCR of Open Interest. Open interest measures all the open positions in options and indicates the bias of the market. As an analyst or a trader you can focus on the PCR (Volumes) and the PCR (OI). Let us see the detailed interpretation.

How to interpret the PCR ratio and what does it indicate for a trader?

There is no range for PCR but normally the PCR hovers around the “1” mark. When the PCR goes well below the 1, then it is an indication that traders are buying a lot more call options than put options. That means relatively more traders are bullish on the stock or the index. On the other hand, if the PCR goes well above 1, then it is an indication that traders are buying a lot more put options than call options. It means more traders are bearish.

Interestingly, the actual interpretation is that PCR is used as a contrarian indicator. That is because retail investors are normally the buyers of options while better-informed institutions and proprietary desks are the sellers of options. Thus a rising PCR will be seen as a contrarian bullish signal as it indicates that fewer institutional traders are willing to sell calls. Similarly a falling PCR will be seen as a contrarian bearish signal as it indicates that fewer institutional traders are willing to sell puts.

Unravelling the sub-plot on the PCR:

The PCR has to be actually interpreted with respect to the real market situation. It is not just the value of the PCR but also the direction of the PCR that matters. For example if PCR is sharply decreasing when the market is close to the resistance, then it is an indication of aggressive writing of calls and is a bearish indication. On the other hand if the PCR is rising in a higher-top / higher-bottom market, it is an indication that puts are being written at each dip and that is bullish signal. To be more precise, one can also combine this with the IV data and get more precise indications.